Former Fannie exec surprised by extent of crisis

RonaldD. Orol

WASHINGTON (MarketWatch) -- Facing a barrage of questions about problems with Fannie Mae's capital, leverage and risk management during the buildup to the financial crisis, two former housing officials defended their tenure and said the mortgage giant was engulfed by an unprecedented decline in home prices that was catastrophic and unforeseeable.

"Few if any predicted the unusual and rapid destruction of real-estate values that occurred," Robert Levin, former executive vice president and chief business officer of Fannie Mae told a financial-crisis inquiry panel.

"In hindsight, if we and the industry as a whole had been able to appreciate the nature and extent of the crisis, it is clear we all would have conducted our business differently during this period, but we like everyone else were surprised by the unprecedented extent of the economic crisis."

Both Levin, who spent 27 years at Fannie until 2008 and Daniel Mudd, president of Fannie between 2005 and 2008, argued that the growth on Wall Street of the private-label mortgage securities market drove the mortgage-finance giants into problematic loans.

Fannie Mae
FNM, +2.52%
and Freddie Mac
FRE, +0.00%
purchase whole mortgages from banks and other direct lenders and package them, as a means of ensuring that adequate capital is available to banks and other financial institutions that lend money to home buyers.

During the buildup to the financial crisis, the two entities were hybrid public-private entities -- so-called government-sponsored entities -- that sought to increase their stock price and compete with Wall Street, while meeting low-income housing goals set by the Housing and Urban Development Department.

Starting in the 1990s through 2006, Fannie and Freddie experienced a dramatic rise in the risk they took on their balance sheets, along with an erosion of underwriting standards. At the height of the financial crisis, on Sept. 7, 2008, they were essentially nationalized to avoid losses and stem the credit contagion. They were taken over by the government in a conservatorship.

Members of the crisis-inquiry panel, known as the Financial Crisis Inquiry Panel, grilled the two executives over how they failed to hold sufficient capital to survive the meltdown. One panel member expressed outrage over the entities' leverage, and another charged both Mudd and Levin with retaining pay packages that drove the two entities to compete more heavily with riskier investments made by Wall Street. Yet another indicated that Fannie Mae's expansion into riskier loans contributed to an expansion of riskier loans across the whole housing market.

Panel member Peter Wallison, a fellow at the American Enterprise Institute, insisted that the housing giants' affordable-housing goals -- which increased during the period leading up to the crisis -- contributed to their downfall.

"HUD was pressing you to continue to make more investments in these affordable-housing loans between 2005 and 2007," he said.

Forced into a change in strategy

Levin and Mudd argued that in a key period, in 2005 and early 2006, the dollar volume of private-label mortgage securities issued by Wall Street outpaced mortgages securities issued by Fannie Mae, Freddie Mac and Ginnie Mae combined.

The two executives said that they needed to expand into riskier mortgages to compete with the private industry. Private-label mortgage securities, or PLS, "posed a financial threat to the company because there was less business going into our market," added Mudd. "It posed a mission threat, because many of the products financed by PLS had affordability features that threatened our ability to meet our housing goals, and it threatened our customers, who didn't want to do business to us."

Levin contended that during that period in 2006 he and other executives at Fannie Mae asked, "would we best be able to deliver competitive returns to shareholders, stay relevant to customers and meet our mission requirements by doing nothing new, or by increasing our participation in these markets to some degree?"

He said that eventually the considerations led to a management consensus to expand Fannie Mae's already existing Alt-A business over time. Alt-A loans are alternative-documentation loans primarily driven by credit scores, where borrowers tend to lack proof of income from traditional employment..

Leverage?

Phil Angelides, chairman of the crisis panel and formerly California state treasurer, expressed concern about the level of leverage Fannie Mae had accumulated during the buildup to the financial crisis. He specified that at one point Fannie Mae had a leverage debt-to-equity ratio of 62 to 1.

"You weren't alone; Goldman Sachs
GS, -0.14%
was doubling its leverage at the time, but what were you thinking in terms of that extraordinary level of leverage?" asked Angelides.

Mudd replied that the mortgage giants were under pressure to compete with private industry while the hybrid entities strived to meet their housing goals. "For Fannie and Freddie Mac to attract global capital, we had to be able to provide a competitive return for that capital comparatively with other financial institutions," he said.

Panel member Douglas Holtz-Eakin sought to identify how Fannie Mae and Freddie Mac's internal risk procedures failed to identify the level of losses the entities would eventually experience. He also wondered how the entities' risk models weren't updated sufficiently after the entities' previous worst-case scenarios failed.

"My interest is internal risk-management procedures at Fannie Mae, which ultimately failed and left taxpayers with the single largest bill we will face in this episode," said Holtz-Eakin. "You have already said you held enough capital despite evidence to the contrary."

In response, Levin said that Fannie Mae had independent risk-management board committees, a chief risk officer and others that sought to update their economic models, but were unable to "catch up with the reality."

Next on the agenda

After Levin and Mudd, the panel heard from James Lockhart and Armando Falcon, both former heads of the Fannie Mae and Freddie Mac regulator, the Office of Federal Housing Enterprise Oversight, during the buildup to the crisis. That regulator was transformed into the present-day Federal Housing Finance Agency.

Lockhart headed OFHEO starting in May 2006 until August 2009, when it already had been transformed into the new FHFA. He told the crisis panel that HUD pushed its housing goals too high, driving Fannie Mae and Freddie Mac to lower their underwriting standards and increasing their exposure to riskier mortgages.

He added that these housing goals also indirectly encouraged the entities to buy private-label securities, which also contributed to lower standards. "I believe that high affordable-housing goals and the resulting political pressure, compounded by [Fannie and Freddie's] drive for market share and short-term profitability, were major reasons why they lowered their underwriting standards."

Specifically, Lockhart said that having 55% of the entities' mortgages be made to borrowers below the median-income household levels in a particular area was "mathematically difficult and a mistake."

Lockhart recommended creating a countercyclical capital regime for the housing entities, so capital requirements increase when housing prices "get too far above trend lines." He also recommended that, whatever structure the entities are reformed into, they should have contingent capital that would convert from debt to equity if capital levels fell below certain levels.

Bailout

Former Treasury Secretary Henry Paulson put a ceiling of $100 billion for investments in each company, but in February 2009, his successor Timothy Geithner raised the cap to $200 billion each.

In December, the Treasury said it would provide unlimited financial support to ensure the survival and liquidity of Fannie and Freddie for three years. So far, the two mortgage entities have received $127 billion in taxpayer support.

Congress and the Obama administration have began efforts to reform the problematic government entities. The Treasury isn't expected to release a detailed proposal for reform of Fannie and Freddie until later this year.

Geithner said last month that explicit government guarantees for Fannie Mae and Freddie Mac can form the foundation for promoting good mortgage-underwriting standards and ease the adverse effects of stress in the financial system on the broader economy.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.